A Delaware bankruptcy judge has ruled in the SemCrude bankruptcy that the claims of Texas producers for unpaid revenues from oil sales are subordinate to the claims of SemCrude’s bankers. As a result, the Texas producers (and perhaps their royalty owners) may lose up to $57 million.

SemCrude filed for protection under Chapter 11 of the Bankruptcy Code in July 2008. SemCrude was a large purchaser of crude oil in Texas and seven other states. At the time of the filing, the SemCrude entities owed their banks $2.55 billion. It also owed more than one thousand oil and gas producers millions of dollars for oil purchased but not paid for in June and July 2008, including $57 million owed to oil and gas producers in Texas.

The court in the SemCrude bankruptcy recently ruled that the claims of Texas Producers for the $57 million in unpaid proceeds of oil and gas sales are subordinate to the claims of SemCrude’s Banks, who hold liens on all os SemCrude’s assets, despite a Texas statute that grants the Texas Producers a lien on their production and all proceeds of sale to secure the purchaser’s obligation to pay.

The arguments made in the dispute between the Banks and the Texas Producers are complicated because they involve the interpretation of Article 9 of the Uniform Commercial Code, a code that has been the bane of many law students’ studies. The judge’s ruling will be appealed and so is not the final word on the matter, but if the ruling stands it will adversely affect the rights of royalty owners in bankruptcy proceedings of oil and gas purchasers and producers, and could greatly reduce their rights to recover payments for their royalties.

Here is a simplified summary of the judge’s ruling:

The oil industry in Texas last fell on hard times in the early 1980’s. Several large oil purchasers filed for bankruptcy, leaving many royalty owners and producers unpaid. In response, the Texas Legislature passed a law intended to give producers and royalty owners a better chance to recover their monies in bankruptcy court. The statute is now Section 9.343 of the Texas Business and Commerce Code, which is Texas’ version of the Uniform Commercial Code. All states have passed their version of the Uniform Commercial Code (UCC). The UCC is intended to govern rights of parties in commercial transactions, and the intent of having a “uniform” code in all states is to ensure that such transactions will not be hindered by differing laws from state to state. Article 9 of the UCC governs security interests granted in “goods.” “Goods” includes oil and gas, once they have been produced. So, the UCC, and particularly Article 9, govern how security interests are granted in produced oil and gas and in proceeds from the sale of oil and gas, and the priority among creditors claiming security interests in oil and gas and proceeds.

Section 9.343 of the Texas Business and Commerce Code, passed by the Texas Legislature in 1983, is a “non-uniform” provision of the Code – that is, it is unique to Texas. It provides that producers and royalty owners have a security interest in oil and gas produced from their properties to secure the purchaser’s obligation to pay for that oil and gas. Under other provisions of Article 9, the holder of a security interest must “perfect” its security interest by filing a “financing statement” in order to have priority over others who claim security interests in the same oil and gas. Whoever files a financing statement first and thus perfects its security interest has priority over other creditors who claim security interests in the same oil and gas. But Section 9.343 provides that producers and royalty owners do not need to file financing statements in order to perfect their security interest. Furthermore, the Legislature provided that the security interest granted to producers and royalty owners is a “purchase-money security interest,” which entitles it to a kind of super-priority over other claimants.

In the SemCrude bankruptcy, Texas producers who sold to SemCrude claimed that they had security interests in the oil and gas they sold to SemCrude in June and July 2008, and in the proceeds from SemCrude’s sale of that oil and gas, under Section 9.343. They also claimed that their security interest was superior to the security interests SemCrude had granted to its Banks in the same collateral. In other words, the Texas producers argued that they should be paid $57 million before SemCrude’s Banks receive any money from the bankruptcy.

SemCrude was organized as a corporation in Delaware. Its principal bank accounts, from which it pays all producers and royalty owners, is located in Oklahoma. So the first issue the bankruptcy court had to decide was which state’s laws applied to the claims of the Banks and the Texas Producers. The commercial codes of Delaware, Texas and Oklahoma all have an identical provision that deals with this issue. That provision, Section 9.301, says that, to determine whether a security interest in collateral is properly perfected, the court must apply the law of the state where the debtor was organized – in this case Delaware. Section 9.301 contains an exception to that rule for “cash proceeds” from the sale of goods. For such cash proceeds, the bank’s jurisdiction’s law governs. Since SemCrude’s bank where the cash proceeds from its sale of oil and gas were held is located in Oklahoma, the law of Oklahoma governs perfection of security interests in that collateral. Under either Delaware or Oklahoma law, the Texas Producers would have had to file financing statements in Delaware or Oklahoma to perfect their security interests in the oil and gas and cash proceeds. Because they did not do so, the security interests granted to the Texas Producers by Texas Section 9.343 were held to be subordinate to the Banks’ security interests. In other words, the Banks win.

There is another exception in the Delaware statute to the general rule that Delaware’s law governs perfection. It says that, while goods are located in a jurisdiction, the local law of the jurisdiction governs the perfection of a security interest in the collateral. So, as to oil and gas purchased by SemCrude that was still located in Texas when SemCrude filed bankruptcy, Texas law would govern priority of the Texas producers’ security interests. To that limited extent, the court ruled that the Texas Producers’ claims would have priority.

The bankruptcy court also addressed how the dispute between the Texas Producers and the Banks would play out if Texas law applied to their dispute. The court held that, if Texas law applied, the Texas producers would have priority as long as the deed, lease or other instrument that gave them an interest in the land from which the oil and gas was produced was filed before the Banks’ financing statements covering the same collateral.

What does all of this mean for Texas royalty owners? If the court’s ruling stands, the protection afforded to royalty owners by Texas’ Section 9.343 may be eliminated if the company paying their royalties is organized in another state or keeps its bank account in another state.

Royalties may be paid either by the operator of the well or by the purchaser of production from the well. Most gas royalties are paid by the operator, but oil royalties are often paid by the oil purchaser. If the purchaser pays the royalty pursuant to a division order signed by the royalty owner, and if the purchaser goes into bankruptcy, the royalty owner may have no recourse against the operator for the unpaid royalty. If the operator pays the royalty and goes into bankruptcy, Section 9.343 may not protect the royalty owner if the operator is organized in another state or pays royalties from a bank account located in another state. Finally, if the operator pays the royalty and the operator’s purchaser goes into bankruptcy, the royalty owner should insist that the operator is nevertheless liable to pay the royalty and should bear any loss resulting from the bankruptcy.

Regardless of the final outcome of the SemCrude case, Texas royalty owners who receive a notice of bankruptcy from a company that pays them royalties should always file a claim in the bankruptcy asserting their right to a security interest under Section 9.343 of the Texas Business and Commerce Code.

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